Departed Executive Reflects on Trying Year for CalPERS –

Michael Flaherman, recently appointed senior adviser at New Mountain Capital, is known to most of our readers as a board member of the California Public Employees’ Retirement System (CalPERS), where he was also chairman of the fund’s investment committee. Flaherman served at Calpers from 1994 through 2002, trying times for the nation’s largest public pension fund, which suffered unprecedented losses of assets totaling $43.5 billion between June 2000 and September 2002. Adding to Calpers’ problems is the decline of the institution’s private equity investments ($200 million was allocated 2002) down 10.11% in value for the first six months of calendar 2002.

If that’s not enough, CalPERS was publicly embarrassed by reports that it recognized serious problems with Enron’s infamous off-the-books partnerships as early as December 2000 but did not blow the whistle. And then there was the lawsuit by the San Jose Mercury News, ultimately forcing CalPERS to reveal performance data on its private equity investments, potentially straining its hard-won relationships with leading venture firms. To top it off, there was an exodus of talent, with six senior staffers and board members leaving for greener pastures amidst press reports of internal problems.

One of those to depart was 37-year-old Flaherman, who began his new job at $770 million buyout fund New Mountain Capital in January of this year. New Mountain, among the firms in which Calpers had invested during Flaherman’s tenure, was formed in 2000 and focuses on mid-market companies in growth industries. Among other things, Flaherman will work closely with the firm’s limited partners and help to evaluate new investment opportunities.

Given all that’s gone wrong in the last year, you can’t really blame the guy for wanting out of CalPERS. But that’s not the way he sees it. Flaherman insists he loved every minute of the job-well, almost every minute-and that he was simply ready for the next challenge in his life. “It was the right point in time to do something else rather than becoming complacent,” he says. “My position on the CalPERS board was an elected one with a four-year term. I decided not to run for another term. I’d already been on the board for the last eight years, which is a long time to do any one thing.”

Sitting with Flaherman on a late December morning in San Francisco’s Pacific Heights neighborhood, it’s hard not to believe every word he says. His sparkling blue eyes and boyish charm exude honesty. He speaks deliberately, choosing his words with care. Still, he’s not afraid to point out his own shortcomings or to launch criticisms at the venture capital community.

When asked to name the biggest problem facing the venture world these days, Flaherman has a simple answer: a breakdown of trust. “The bedrock of all commerce is trust,” he says. “There is good reason for believing that Silicon Valley was built on the trust between venture capitalists and the lawyers who set up venture-backed companies, the accountants who devised the options plans, the landlords who leased space to entrepreneurs with no credit worthiness, and most important the employees who took the risk to work for venture-backed firms.”

Flaherman contends that this trust is now greatly strained, as VCs made off with incredible profits while many entrepreneurs and employees were left with next to nothing. Instead of trying to rebuild that broken trust, and in essence, rebuild their entire industry, “venture capitalists are too busy whining about the money they are now losing and fretting over the opening of the next IPO window. An incessant topic of conversation is: When will things stop getting worse?'” he says. “I believe the answer is: When VCs stop trying to restore a shattered status quo and start trying to rebuild the broken trust.”

It’s somewhat ironic to hear Flaherman talk about trust, especially since one of his biggest mandates at CalPERS over the past few years was to win the trust of venture capitalists who had previously scorned the fund because of its unfriendly, overbearing approach. “We did miss the boat,” he admits. “If you ask the senior partners at some of the oldest firms in Silicon Valley, they will tell you the story of how in 1989 they trekked to Sacramento to visit with CalPERS, which had just hung out its private equity [sign], and how their efforts were fruitless. Either they couldn’t get a meeting or they couldn’t make their case. We suffered from that because it was those guys who ended up owning the venture business.”

The rift was further exacerbated in the mid 90s, when CalPERS led an aggressive initiative to force private equity firms to lower their management fees. It was the worst possible timing. The initiative only succeeded in alienating venture capitalists, who were just starting to hit their stride and bring home massive returns to their investors. “We weren’t reflective enough on the timing of what we were doing,” concedes Flaherman.

Over the years, however, Flaherman, along with CalPERS’ private equity team (previously led by Barry Gonder and now Rick Hayes) mended many fences. Flaherman met personally with scores of VCs to prove that CalPERS was serious about the asset class. At a time when other pension funds where retreating from the industry, CalPERS’ investment committee last year increased its private equity allocation from 6% to 7%. That’s a far cry from the 4% allocation when Flaherman first joined the board.

But the legacy of goodwill that Flaherman helped to establish may now be in serious jeopardy thanks to the San Jose Mercury News and a recent court ruling requiring CalPERS to publicly disclose private equity performance data. Many top venture firms have been whispering, sometimes shouting, that they will no longer accept money from pension funds if it means their IRRs will be put on public display.

Flaherman is torn by the issue. After all, CalPERS has to answer to 1.3 million government employees. “It’s hard to say there shouldn’t be some ultimate level of accountability,” he says. “People ought to have some way of knowing that the pension system isn’t throwing away money on things that are clearly not prudent or tainted politically.” On the other hand, he believes CalPERS needs to defend the agreements it signed with venture firms promising not to reveal performance data. Furthermore, he believes that some firms may be harmed by the disclosure. “Say you are a private equity firm with a niche strategy that consistently returns above average,” he says. “It’s possible that you could be harmed by a flood of new competition from firms who would never have pinpointed your niche in the past.”

That said, he believes it’s a grave mistake for venture capitalists to turn their backs on public pension funds and focus solely on raising money from private endowments and wealthy individuals. “The danger is that if the very best funds wash their hands of public money, you could end up with the bifurcation of the private equity industry where the opportunity set available to endowments and similar institutions is much more attractive than what’s available to public institutions,” he explains. “If that became so large scale and blatant, then this ultimately becomes a political issue.”

As things stand now, endowments benefit from tax laws, as do VC firms, which make most of their money in the form of capital gains, not personal income. It is not out of the question, says Flaherman, that tax laws could one day be amended if it is proved that some investors have greater opportunities than others. “The problem is that the GPs who are making decisions today don’t really care because they won’t be around in a generation or two when the problem comes home to roost,” he says.

Moving forward, Flaherman is excited about his new role at New Mountain Capital, where his first order of business will be establishing close relationships with the limited partner community. One pension fund he won’t be working with, though, is CalPERS. Under California law, he cannot personally conduct business with the fund for one year.


Tom Stein is a freelance writer who covers the Silicon Valley venture capital industry.